ONGOING GOVERNMENT INVESTIGATIONS INTO THE ACCOUNTING practices of the nation's two largest secondary mortgage financing institutions have certainly gotten home builders' attention. And now those agencies—Fannie Mae and Freddie Mac—face draconian reform measures that, if realized, could be even harder for the housing industry to ignore.

By the end of this year, HUD, which establishes the missions for both agencies, should make public its ruling on new targets for affordable housing investment by Fannie and Freddie. And sometime in 2005, Congress is expected to take another stab at reforming those agencies and home in on revamping their regulatory and program approval oversight.

The NAHB this summer registered its objections to HUD's proposed targets, which would raise Fannie's and Freddie's investment in affordable housing mortgage financing to 57 percent of their respective portfolios by 2008, up from 50 percent this year. And other housing industry officials are anxious that the two agencies could wind up under the regulatory yoke of the U.S. Treasury, which hasn't been shy about expressing its antipathy toward Fannie's and Freddie's expansion.

Builders are letting the NAHB do the heavy lifting to protect their interests but are confident that the American mortgage finance system will somehow manage to survive this latest political imbroglio. “The government has to move gradually in this area and take measured steps over time,” predicts Jim Shontere, CFO for Shea Homes in Walnut, Calif. “Fannie and Freddie have been allowed to become so dominant, and home building is such an important part of the economy.”

But there may be more going on here than simply another turf battle between government bureaucracies. “What started out as an accounting issue has ballooned into a debate about the entire overhaul of [Fannie and Freddie] and a referendum on the financing of the housing industry,” observes Jerry Howard, the NAHB's chief executive. An alarmist tone can also be detected in comments from David Hill, president of Illinois-based Kimball Hill Homes, which caters to affordable home buyers in several of the 17 markets where it builds. Hill says he's followed this debate for 25 years and is convinced that if the Treasury starts setting the agenda for Fannie and Freddie, “the affordable housing crisis in the United States will get significantly worse.”

Other housing officials fear the prospect of Fannie and Freddie being reined in to the point where they become risk averse and less innovative at a time when the housing market needs all the creativity it can muster to accommodate a buyer universe whose composition is more variegated and complex than ever, with hordes of immigrants, aging baby boomers, and single-income and women owners pushing their way onto center stage. “For the building industry to respond to new opportunities, it needs products that are adaptable,” says Conrad Egan, president of the Washington-based National Housing Conference.

Success Breeds Apprehension That Fannie and Freddie are the 800-pound gorillas in the secondary mortgage market is indisputable. At the conclusion of 2003, the two agencies aggregately owned or guaranteed an estimated 43 percent of the nation's $7.8 trillion in outstanding mortgage debt. Between 1999 and 2003, Fannie's portfolio, the larger of the two, increased to $898 billion, nearly 70 percent. Freddie's chairman and CEO, Richard Syron, recently claimed that his institution backs a mortgage every six seconds.

Kent Colton, a former NAHB official and now senior scholar with Harvard's Joint Center for Housing Studies, recalls that when he chaired President Reagan's National Housing Council in 1984, “the big question then was where the money to expand the market would come from. Of course, it came from the GSEs,” he says, referring to government-sponsored enterprises such as Fannie and Freddie. In 2002, when President Bush called upon the nation's housing industry to invest $1 trillion to create another 5.5 million minority-owned households, “front and center in Bush's speech were Fannie and Freddie,” notes Nick Retsinas, the Joint Center's director.

Fannie's and Freddie's success and influence, however, regularly draw flak from certain commercial banking and investment quarters that believe that too much capital flows into the housing market, that the agencies' investment strategy too often strays beyond the boundaries of their charters, and that federal subsidies—in the form of exemptions from taxes and securities-registration requirements as well as a $2.25 billion line of credit from the Treasury—which allow the agencies to borrow money at costs below those incurred by other publicly traded lenders, perpetuate the erroneous perception that their liability is protected by the government. (In fact, the Bush administration has been angling for the authority to take the GSEs into receivership in the event they default.)

Powerful and mostly conservative forces in the press, the business community, and the federal bureaucracy have been emboldened by controversies swirling around Fannie's and Freddie's accounting practices and aggressive growth to press for overhauls in their regulatory and program oversight. “We now face significant pressure in Washington from people who believe that the market alone can meet housing demands,” said Syron in a speech to the U.S. Conference of Mayors in Boston on June 26. “This opposition has many faces, including mortgage financiers in the private sector who would like to see the government-sponsored entities like Freddie Mac go away and their own profit opportunities improve.”

Federal Reserve chairman Alan Greenspan and the think tank American Enterprise Institute are among those that have been beating the privatization drum loud and often, although Retsinas points out that no lawmaker has ever offered legislation calling for that measure.

Still, a fairly broad consensus has formed around scuttling the Office of Federal Housing Enterprise Oversight (OFHEO), which regulates both GSEs, and replacing it with an entity that has more enforcement teeth to bolster the agencies' safety and soundness. “The current structure simply isn't working,” asserts Dr. John Weicher, HUD's assistant secretary for housing and commissioner of the FHA. Egan adds that at a time when their financial probity is under fire, the GSEs can't recover their credibility until a regulator with some recognizable stature is appointed. “OFHEO doesn't live up to that standard,” he states.

Treasury's Role Debated But what would? Weicher says HUD supports a broader regulatory oversight role for the Treasury, which Howard of the NAHB counters would be “divisive” and “a prescription for disaster” because it might limit the GSEs' investment flexibility. “You don't want to throw the baby out with the bath water” by imposing too many restrictions and regulations, says Colton.

Peter Eavis, a reporter for The, recently reported that Fannie and Freddie may have already been “brought to heel” by relentless pressure from pro-reform forces and the threat that debt issuance by the Treasury could be capped at the whim of any administration. This may explain why some industry officials are calling for an autonomous regulator that would be immune to political arm-twisting and not held captive by congressional appropriations, something like what exists at the Federal Deposit Insurance Corporation.

“Our position is in favor of a strong, well-funded, and empowered regulator that has the tools it needs for enforcement,” says Doug Duncan, chief economist for the Mortgage Bankers Association. “The whole financial system would benefit [from better regulation] because it would reduce risk and volatility.” The independence of such a regulator, though, “is a very big issue for us,” adds Ann Grochala, director of lending and accounting policies for the Independent Community Bankers of America.

But where Weicher says HUD would also be willing to cede oversight of the GSEs' program approval to the Treasury and serve in a “consultative” capacity, Grochala and others prefer that HUD retain that aspect of oversight “so that Fannie and Freddie don't have to go through a ton of red tape,” she explains. “Ultimately, the consumer would be hurt, because the market develops products in response to buyer demand, and innovation could be restrained if approval needed to go through a separate regulator.”

Targeting Affordable Housing Congress won't start wrestling again over regulatory and program approval oversight legislation until next year, at the earliest. But HUD wants Fannie and Freddie to commit more of their financing activities to affordable housing right now. “We're very much focused on the affordable housing targets, and we want [the GSEs] to take the lead,” says Weicher.

The affordable housing crisis in America is real and growing, as the gap between the rising cost of homes and household incomes continues to widen. The California Association of Realtors estimates that in May, less than one-fifth of that state's households could afford to purchase a median-priced home, the lowest level since 1989. Nationwide, the number of families that pay 50 percent or more of their incomes for housing now represents 13 percent of all homeowners, according to Joint Center data. The ownership rate among working families with children actually fell to 56 percent in 2003, from 62 percent in 1978, according to the National Housing Conference. And the Fannie Mae Foundation estimates that in 2000, 6.1 million households could be classified as “crowded”—that is, with more than one person per room—the largest number since 1960.

In his speech to the mayors, Syron conceded that Freddie Mac “hadn't done as much as it can do to increase the supply of affordable housing,” which targets potential buyers earning 100 percent or less than their respective market's median household income levels. Responding to Bush administration pressure, Fannie and Freddie are currently involved in nationwide community outreach programs designed to bring more low- and moderate-income families into the ownership arena (see “Closing the Affordability Gap,” above). In 2003, Fannie financed $246 million in loans to minority families, an 81 percent increase over the previous year.

Apparently, HUD officials still think the GSEs are falling short. But HUD's new targets make housing officials nervous because they could force Fannie and Freddie into what Egan calls “aberrant behavior” by reducing their overall investment activities to meet certain ratios. He calls this “playing the denominator,” and some Democrats and housing executives suspect this is the government's real purpose. Egan, Hill, and others also suggest that Fannie and Freddie might start “raiding” mortgage markets currently served by the FHA, thereby diminishing that agency. (Weicher dismisses this argument, claiming it's been made time and again over the past 30 years, “and FHA is still standing.”)

A clearer picture of the GSEs' performance, says Syron, would be painted if HUD calculated their affordable housing investments based on new-home loans and excluded refinances. The NAHB has called for a “more balanced approach to affordable housing,” says Howard, that doesn't lock Fannie and Freddie into rigid quotas for every market and, hypothetically, that would credit them for targeting rural and low-income areas where affordable housing may be needed most.

Reassessing Risk Builders say they can't get too worked up about this debate because, as Shontere of Shea Homes notes, “there's plenty of liquidity out there” and lots of mortgage financing alternatives. “It is highly unlikely that Congress is going to do anything to kill the golden goose,” says Steven Hilton, co-CEO of Plano, Texas–based Meritage Homes. Colton is confident that as long as the home building industry stays involved, “compromise will be reached” within financial and legislative circles.

What no builder wants, though, is a mortgage financing environment that is so constrained as to limit access to creditworthy buyers. Historically, Fannie and Freddie have been willing to experiment and to offer financing to buyers where other lenders have feared to tread. The questions that are likely to be answered in the coming months, then, are: How much risk will lawmakers allow Fannie and Freddie to take? How much will be sacrificed for the sake of their long-range financial integrity? and, What role will the GSEs be permitted to play in backing a housing market whose sustained growth hinges on its ability to provide creative, flexible mortgage solutions to potential home buyers whose circumstances and needs will always be as different and individual as the buyers themselves?

“Rather than look at the current pie,” says Egan, “the challenge we all face is expanding the pie. The process has to be one that rewards innovation.”

John Caulfield is a freelance writer based in Old Bridge, N.J.

Battle Lines Starting around 2000, critics began expressing nervousness about the potential risks that Fannie and Freddie pose to the U.S. housing market and the entire American financial system. Reformers sprang up in many areas of the federal government, including the White House, Congress, HUD, the Treasury Department, and the Federal Reserve Board. Here are some of the major pro-reform players and their comments:

President George Bush has called for tougher regulation of the government-sponsored enterprises (GSEs) across the board. The Bush administration, through HUD, introduced new rules that would increase the amount of mortgages to low-and moderate-income borrowers that the GSEs carry. Also, the administration seems eager to use existing rules, this time through the Treasury Department, to restrict debt issuance by the GSEs.

“I have called on Congress to create a new regulatory regime that establishes a single financial regulator with the full range of supervisory and enforcement powers that are comparable to other world-class financial regulators.”

Alan Greenspan, Chairman, Federal Reserve Board—His remarks last February that Fannie and Freddie might pose a threat to the United States' financial system if their ability to assume new debt was not curtailed started a firestorm. At that time, he “strongly recommended” an effective regulator for Fannie and Freddie. Greenspan also suggested that withdrawing the backing of the government from the GSEs would spur competition and create a more efficient mortgage market. But he seemed particularly aggrieved by those investors who buy GSE debt and assume that the government will cover their investments in the event of a default.

“The GSEs' special advantage arises because, despite the explicit statement on the prospectus to GSE debentures that they are not backed by the full faith and credit of the U.S. government, most investors have apparently concluded that during a crisis the federal government will prevent the GSEs from defaulting on their debt.”

Alphonso Jackson, Secretary, HUD—Jackson's role has been to apply pressure on the GSEs with regard to the kinds of business they take on. On the job only a short time, Jackson has already taken some tough stands. Late last year, HUD decided not to offer housing bonus points to Fannie and Freddie. Such points, awarded for financing small apartment buildings for low-income buyers, would have helped the companies achieve their HUD-set goals.

The Bush administration “has proposed that HUD have the ability to set an enforceable goal encouraging the purchase of first-time home buyer mortgages. This portion of the reform is designed to ensure that Fannie Mae and Freddie Mac lead, not lag behind, the market.”

Armando Falcon Jr., Director, Office Of Federal Housing Enterprise Oversight, says the OFHEO has the necessary expertise as well as 10 years of experience in monitoring the finances of Fannie and Freddie. He also contends that the GSEs are well capitalized—well enough to make it through a long bout of depression in the housing industry. Although Falcon will not be seeking a second term as director, the agency is expected to continue to resist any attacks on its outright authority.

“There's a strong possibility that simply moving boxes on an organizational chart will do more harm than good.”

John W. Snow, Secretary Of The Treasury, has recommended that Treasury, having more financial savvy, take over the oversight of the GSEs for HUD. He has also taken a hard line on the GSEs' federal line of credit. When asked if Congress wanted to take on the issue of repealing the credit line, a Treasury official said, “We're open to having that discussion.” Like Greenspan, Snow is disturbed by the public perception of government guarantees for the GSEs.

“There is a general recognition that the supervisory system for housing-related GSEs has neither the tools nor the stature to deal effectively with the current size, complexity, and importance of these enterprises.” On the guarantee issue, Snow declared, “The reality is that the market treats the paper as if the government is backing it. We need to disabuse people of that perception. Investments in Fannie and Freddie are uninsured investments.”

Jerry Howard, CEO, NAHB—While the NAHB supports naming the Treasury Department the financial regulator of the GSEs, it objects to giving new-housing program oversight to it. “There is a fairly transparent inherent bias against housing in Treasury,” says Howard.

“Fannie Mae and Freddie Mac are extremely critical components of this nation's housing delivery system. That we have become the best-housed nation in the world is due in large part to the contributions of these two companies.”

Rep. Richard Baker (R-LA.), Chairman, Subcommittee On Capital Markets, Insurance And GSEs, introduced a bill in Congress to abolish the OFHEO and give oversight of the GSEs to the Treasury Department. A longtime critic of Fannie and Freddie, Baker seems most concerned that taxpayers will have to cover losses caused by a collapse of the mortgage giants. Baker was able to garner some support for his bill because of Fred-die's financial troubles.

Freddie's accounting irregularities are “a symptom of a much larger problem” with regulatory oversight, says Baker.

How Big Are They? The housing GSEs' outstanding mortgage-backed securities and debt, year-end 1990 and 2002:

At the end of 2002, mortgage giants Fannie Mae and Freddie Mac, along with the much smaller Federal Home Loan Banks, whose debt is included in the totals below, possessed outstanding securities in excess of $4 trillion, more than the entire United States public debt. The residential portion of that total, as shown in the chart, approached 57 percent of all residential mortgage debt in the United States in 2002.

Closing The Affordability Gap Agencies step up their efforts to provide broader financing options to low-income and minority home buyers.

The debate over where Fannie Mae and Freddie Mac should be directing their capital has sharpened the focus on the market's need for more affordable housing and mortgage financing flexibility. “It's time for this nation and its cities and towns to notice the shortage of housing for working families,” says Bobby Rayburn, president of the NAHB.

Rayburn made that comment in support of a program that the NAHB, Fannie Mae, and other public- and private-sector partners launched this spring to revitalize 1,000 communities in 30 markets by expanding their affordable housing stock primarily for municipal employees such as police officers and teachers. This “workforce initiative” is one of several programs Fannie and Freddie have developed or expanded in recent months to increase homeownership levels, with a greater emphasis on affordability.

The agencies' affordable housing efforts coalesce around two omnibus platforms: Fannie's “American Dream Commitment,” which through 2010 will provide $2 trillion in private capital to help 18 million minorities and underserved Americans rent or buy a home; and Fred-die's “Catch The Dream,” a set of 25 separate initiatives that is bringing together business and lending institutions in different markets to expand housing for first-time buyers.

In January, Fannie said it would create six million new first-time buyers over the next 10 years and raise minority ownership to 55 percent, up from 49 percent in 2003. To achieve those goals, Fannie is expanding its annual mortgage purchases serving first-time buyers from an average of 345,000 households during the years 2000 through 2003 to an average of more than 600,000 from 2004 through 2013. Within that parameter, Fannie is increasing its annual purchases serving minorities to an average of 180,000, from 87,000, and will invest more than $700 billion in mortgage financing for minorities. The agency also has programs in place that address homelessness and the lack of available housing for the disabled, for Native Americans, and in poor rural markets. “What you're seeing is the fulfillment of programs we've been rolling out the past few years,” says Julie Gould, Fannie's vice president of community lending.

In June, Freddie took Catch The Dream to St. Louis, where the agency joined a $15 million public–private-sector joint venture to expand affordable housing for low- and moderate-income families through new financing and land-development instruments. Freddie signed on to a similar, $25 million project in New Orleans earlier this year.

Both Fannie and Freddie are striving to provide communities with more diversified financing options and educational support. On Jan. 1, Fannie offered “My Community Mortgage,” a program through which lenders can create community-specific mortgages and customize and streamline the borrowing process by using the agency's automated underwriting system, called Desktop Underwriter. Over the past eight months, Freddie has been using a small fleet of buses to transport lenders to a central location within a community such as a church or school, where local residents can go to get the answers to questions about how they can get started buying a house and what it will take financially to keep the home. “In one city, more than 1,000 people came onto the bus, out of which we got 75 mortgages,” says Patricia McClung, Freddie's vice president of affordable lending.